As is well known, a loan is an advance of money from a lender to a borrower over a period of time. The borrower is obliged to repay the loan either at intervals during or at the end of the loan period together with interest. A home equity loan product, such as a home equity loan or a home equity line of credit, is an amount of money a homeowner can borrow against his or her home equity. A home equity loan (HEL) provides a borrower with a lump sum of money and carries a fixed rate. A home equity line of credit (HELOC) differs from a conventional HEL in that the borrower is not advanced the entire sum up front, but uses the line of credit to borrow sums that total no more than a certain amount. A borrower with a HELOC pays interest only on the amount withdrawn, or borrowed. However, the interest rate on a HELOC is variable based on an index such as prime rate. This means that the interest rate can, and typically does, change over time.
Record numbers of homeowners have been turning to home equity loan products as a source of ready cash to help finance major home repairs, medical bills, or college educations. Indeed, analysts believe that an annual two-digit increase in home equity lending in recent years may reflect a fundamental shift in consumer borrowing habits.
HELOC loans have become especially popular, in part because interest paid is often deductible under federal and many state income tax laws. This effectively reduces the cost of borrowing funds. Another reason for the popularity of HELOCs is flexibility not found in most other loans—both in terms of borrowing “on demand” and repaying on a schedule determined by the borrower. Furthermore, HELOC loans' popularity growth may also stem from their having a better image than a “second mortgage,” a term which can more directly imply an undesirable level of debt.
In order to understand their home equity business and correctly set interest rates, i.e., price, for their HELs and HELOCs, financial institutions need to understand the effect of interest rate changes on their loan portfolio performance. That is, rate changes can elicit a number of customer behaviors, or responses. These customer behaviors include, for example, applying for a new HEL or HELOC, referred to as an origination behavior, and/or utilizing more balance of their existing account, referred to as a utilization behavior. Other customer behaviors responsive to rate changes include increasing their line of credit, referred to as a line increase behavior, and extending or shortening the life of their existing loan, referred to as a loan life adjustment behavior. A recent development in home equity loan products is known as a fixed-rate loan option (FRLO). An FRLO allows a borrower to take fixed-rate loans from his HELOC. Thus, a borrower can take advantage of variable interest rates while they are low, and convert to fixed rates when they start to climb. This conversion to an FRLO is referred to as a fixed-rate conversion behavior.
If a financial institution lowers the interest rate, i.e. price, on a particular HELOC product segment, some borrowers may apply for a new loan, others may utilize more balance of their existing HELOC, some may take an FRLO on top of their HELOC, some borrowers may increase their lines of credit, and still others may extend the life of their existing loans. Consequently, changes in interest rate, i.e., the price of a loan, can affect total loan volume through all five of these customer behaviors.
An understanding of the effect of interest rate changes on loan portfolio performance, calls for careful analysis of the potential channels, or customer behaviors, that can be influenced by rate changes. A financial institution typically utilizes a simple, static statistic model to estimate the interest rate impact on origination volume, i.e., origination behavior. The financial institution may then use ad hoc data averaging to obtain information regarding the other four types of customer behaviors. Unfortunately, the procedure for forming the estimates is time and labor intensive, and ad hoc data averaging can lead to estimation inaccuracies.
Consequently, what is needed is an automated, dynamic demand modeling system with which a financial institution can accurately and concurrently model multiple types of customer behaviors to gauge an impact that rate change has on loan products, such as home equity loans and home equity lines of credit.